The foreign exchange market is the most sought out among investment alternatives. Forex offers a flexibility and an ease of trading like no other market and trades can happen throughout the week, at any time. This is because there is no one location for trade, in turn it has also been almost entirely self governed by traders and has no limits. It is the 'Wild West' of investments and has a trillions of dollars to trade with every day.
Money does not sleep when people make more money out of it. In reality, the market does not trade any thing. There is no actual trade of money or currency in the Forex market, but instead the trades are made on the value that a particular currency will reach or not reach. It is, in theory possible to pair random currencies with each other and form trades based on them, but these are rare and take up only a minor portion of the total transactions.
The highest traded pair is the EUR/USD, followed by USD/GBP and USD/JPY. Forex instruments are based on the value that the pairs take up. There are Bid and Ask prices set, based on the rate of exchange between the pairs. A Bid price is the price that an investor is willing to pay for the currencies and an Ask price is the one set by the brokers as cost. The gap between these two is known as the spread. These values keep changing constantly and this change forms the basis for trade. If the changes are frequent and violent, it can be called a volatile market.
Volatility can be defined as the level of dispersion around the average return of a security. This, in Forex terms will the fluctuation of a currency value and its rate of exchange over a period of time. If there are many ups and downs on this, it is called a volatile market and a stable market is called a non- volatile market. Price fluctuations are generally high in the Forex market, but there have also been instances where the growth or drop in the market have slowed down or frozen. Investments take a wrong turn and have the chances of losing a lot of money.
Although market volatility sounds like an investment killer on the outset, it is the main driving force for all trades. If the market is not volatile, it will not see any movement. This is also true on the other side of the scale, where it is not possible to make any money off the Forex market unless there is a good level of volatility. Even though it seem counter intuitive, only a volatile market will make money and a stagnant market will, by itself see a drop of trades. Traders are known to stop all activity if there is no fluctuation in the markets as they will not make enough money. A stagnant market is also one that regularly loses money when a forward or future option matures in a stagnant phase.
Why do forex traders care about volatility?
Investors look at various volatility indices due to following main reasons:
- Higher volatility means more risks, and also more opportunities
- Market tends to fluctuate more and by a larger extent
- Some trading algorithms work only with low volatility while others need high volatility
- Risk management techniques need to be adjusted based on the changes in market volatility
- Higher volatility introduces more emotional stress for any trader
- In a higher volatility environment historical correlations between various currency pairs tend to experience short-term deviations
Why does the market get volatile?
There are many factors that influence a currency to lose or gain it's value and cause a wave in the Forex market, but the first and main cause is the performance of the country's economy. If the economy of the country is doing well, the markets growing, inflation in check, the balance of trade is balanced and the government has a favorable monetary policy, the value of currency will grow over time and there will be a positive volatility in the market. If the economy fails, the value of the currency drops and causes negative volatility. If there is no growth or collapse, the market gets frozen and is no good for Forex trading.
Outside factors can also cause volatility. If the base currency's home economy is doing well, better than the one it is compared against, it can show a drop in value. This is especially true when pairing up with the USD. In fact a strengthening USD is an indicator that other currencies will lose some value. This can conversely mean that the overall health of the world's economy can be measured using the USD as a scale.